Anaemic growth and the sovereign debt crisis in Europe have encouraged investors to look to emerging markets in search of returns.
But some managers have doubts about traditional emerging market economies. Opinion is divided as to whether China will have a soft or hard landing and there is concern about the overvaluation of the Brazilian real.
Beyond the traditional emerging sector, frontier markets are gaining in popularity. The MSCI Frontier Markets index is made up of countries predominantly in the Middle East, Asia, Africa and Eastern Europe.
Franklin Templeton executive chairman of Templeton Emerging Markets Group Mark Mobius believes the advance of many frontier market countries toward emerging status presents an economic opportunity.
He says: “Newer markets have more room to grow and the search for growth potential amid acute global volatility is encouraging many investors to expand their horizons.”
Mobius says frontier markets’ access to capital markets is a key ingredient to high and sustainable private-sector-led growth. He adds that political uncertainty has meant this access has long seemed out of reach for many of these countries until recently.
The potential for growth and cheap valuations makes frontier markets attractive. In the £1.9bn emerging markets trust, Mobius has added to MCB bank, the fourth-biggest bank in Pakistan, because of low valuation and a relatively high return on equity.
He has also added to Indian real estate devel-oper Peninsula Land on an expectation that the company will perform well, given scarce supply of commercial space in the central and southern Mumbai business districts.
BlackRock managing director and portfolio manager Sam Vecht feels frontier markets have the fastest growth, least debt, greatest commodities endowments, cheapest valuations and best demographics.
He says: “Dividends are higher than in typical emerging markets. There is the expectation in Islamic countries that companies should pay dividends. The Qatari bank has just paid 7 to 8 per cent dividend yield.”
But the risk that comes with investing in under-developed countries is lack of liquidity, says Vecht. For this reason, his £75m BlackRock frontiers investment trust is close-ended.
He says: “A close-ended vehicle means we can have confidence to invest without worrying about flows in and out of our trust. We have told investors this is a five-year vehicle and it is important to have a long-term view.”
Vecht says 90 per cent of the portfolio is invested in companies with trading volumes of £500,000 a day or more.
HSBC Global Asset Management portfolio manager Andy Brudenell runs the £52m HSBC GIF frontier markets fund. The fund is also open-ended and he believes the flexibility of trading in this structure suits the market.
He says: “The asset class is immature, so a close-ended vehicle might put investors off in terms of restricting when they can or cannot enter and exit. It might benefit the manager, though.”
The minimum market cap the fund invests in is £63.6m and Brudenell analyses daily trading volumes. He says: “I am looking at true sustainable daily volumes because if you look at an average six-month trading volumes, you can get skewed by large liquidity events.”
Frontier markets are less transparent and this, together with corporate governance issues, means on-the-ground research is important.
Brudenell says: “There is a lack of information about the asset class, so you have to do a lot more of your own research to dig into the companies. You have to meet the management team and travel to the region, meaning it is more hands-on than other asset classes where financial information is readily available.”
Political risk also has to be taken into account, highlighted by the Arab Spring, which exposed how turbulent the markets can be. The riots that followed the removal of subsidies on fuel in Nigeria also made some investors question the stability of the country’s economy.
Brudenell says such political risks have to be assessed in terms of whether the environment changes the strong investment thesis on the stocks.
He says: “There are some good value companies that should have a strong return on equity over the next couple of years in Nigeria, particularly in consumer staples or cheap banking stocks with the banking reform that has gone on there.”
Bestinvest senior analyst Ben Seager-Scott says: “I cannot see any stock that is immune from political risk in frontier markets. Most decent frontier market managers look for companies that are less affected in terms of being influenced by their government.
“There is a lot of growth potential in frontier markets but it is unclear how long it will take to realise this potential. Frontier markets are more suitable for long-term, high-risk investing rather than short or medium-term speculation.”